Hedge funds consider the alternatives

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Alternative investing-flavoured mutual funds are not only getting interest and asset flows from advisers spicing up portfolios that failed them in the downturn, they are also attracting hedge fund managers that smell opportunity baking.

Established hedge managers are moving into the regulated fund space by building their own operations or serving as sub-advisers to mutual fund market partners. Recent forays into the retail market by prominent hedge brands such as AQR Capital Management and Permal Asset Management have added to the segment’s momentum.

Morningstar data show alternative-style mutual funds adding $18.9bn of net new assets in 2010 and $12.8bn in 2009, dwarfing the previous nine years, when annual inflows ran from $500m to no more than $5.6bn.

And the alternative segment – which Morningstar divides into bear market, long-short, market neutral, and currency funds – rose from a mere 1.6 per cent of the $294bn in net flows across the mutual fund market in 2006 to 7.7 per cent of last year’s $246bn in inflows.

“It is still a very small slice of the pie, but quickly growing,” says Nadia Papagiannis, alternative investments strategist for Morningstar.

The product proliferation is a response to demand from advisers, who no longer count on commodities, gold and real estate to act as non-correlated assets to traditional portfolios, says Matthew Lemieux, research analyst at Lipper.

Retail alternative funds that are regulated under the Investment Company Act of 1940 are even attractive to wealthy clients. Some have never dabbled in the asset class before and others may switch from higher fee structures such as funds of funds, says Neal Simon, chief executive of Highline Wealth Management, a Maryland-based independent adviser with more than $1bn in assets.

“I could see some investors moving out of funds of funds to the mutual fund versions for both simplicity of tax issues and the much greater liquidity for their investments,” Mr Simon adds, noting that “gates” many hedge funds created to restrict withdrawals during the crash left investors frustrated.

Highline has about a third of its client assets in alternatives, and Mr Simon says a growing share is in mutual funds, including the Princeton Futures Strategy Fund, established by a managed futures fund of funds manager that his firm has used for seven years.

While retail products crafted by alternative firms seldom mirror their restricted funds for institutional and wealthy investors, the longer track record in trading complex securities, using shorting and leverage techniques, and managing counterparty risk gives these managers an edge, Mr Simon says. That is preferable to a long-only mutual fund manager trying its hand at new tricks, he adds.

Still, hedge managers entering ‘40 Act territory must be strategic, because mutual funds present their own operational challenges, says Marco Hanig, president of AQR Funds, the retail affiliate of Connecticut-based AQR Capital.

Building on core expertise in strategies such as managed futures, convertible arbitrage, and market neutral products, AQR added diversified arbitrage and managed futures mutual funds, as well as non-traditional risk parity and momentum funds, which all together have nearly $4.3bn in retail assets.

“We saw a significant opportunity to deliver something that was needed in the retail market,” says David Kabiller, principal and head of client strategies at AQR.

The firm is limiting retail distribution to advisers, and plans additional strategies, Mr Hanig says.

Various hedge managers have taken the sub-adviser route, and their contributions are in demand from mutual fund managers aware they lack alternative investing expertise, says Lipper’s Mr Lemieux. “A lot of mutual fund companies are looking to fill a gap, to be more flexible and have a wider investing mandate,” he adds.

Lipper cites several examples of hedge managers sub-advising retail absolute return funds, including AQR on the Transamerica AQR Managed Futures Strategy, Akros Capital on the Quaker Akros Absolute Return Fund, and Viathon Capital on the Van Eck Multi-Manager Alternatives Fund.

Another prominent relationship is Permal sub-advising a mutual fund with about $115m in assets for its affiliate, Legg Mason. The retail strategy launched in 2009 is new for Permal, but derives from the same core research that fuels the fund of fund firm’s products in areas such as global macro, long-short, and distressed securities, says Josh Levine, its co-head of global sales. The strategy can invest in unregistered hedge funds and use illiquid derivatives and short selling.

“We were looking for something different – a bridge between traditional and alternative investing, and we had a mutual feeling that we had the resources here to express it,” Mr Levine says. The firm benefits from Legg’s mutual fund operations and distribution engine, he adds.

He says the affiliates have more funds on the drawing board, with some set to launch in the coming year.

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